Tuesday, June 08, 2010

Monday, June 07, 2010

Playing the markets is not an easy occupation. One normally thinks that it involves buying at the bottom and selling at the top. But in fact, one must make a new decision every trading day. We had a good illustration of this on Friday, June 4 when gold plunged sharply in the morning, and at the same time the dollar broke out of a small triangle to the upside. Since the dollar often moves opposite to gold, this was a bearish signal for gold. A year’s trading, then requires 250 decisions. A decade’s trading requires 2,500 decisions. Fortunately, to make money we do not need to get all of them right. A good majority will suffice.

(Click on images to enlarge)

Above is a daily basis chart of the U.S. dollar (candlestick) showing Friday’s breakout to the upside confirmed by a high volume day. With gold plunging Friday morning and the dollar breaking out upside, it was a scary moment for gold bugs. Fortunately, gold rallied strongly in the afternoon. It made up all the morning’s losses and put on a solid gain. Indeed, GLD (the gold trading instrument which has the latest close) completed a bullish engulfing pattern, a candlestick signal predicting higher prices.

It seems that the markets are saying that the old scenario of gold moving opposite to the dollar (and with the euro), which dominated much of the last decade, has changed. Now the scenario is that all paper money is collapsing against gold. And for the past 4 months, the dollar’s rise against the euro (and other currencies) has been accompanied by a nice gain in gold.

This illustrates the importance of perspective in trading the markets. All of a sudden, as soon as your own money is at risk, everything looks different. When you were paper trading, you were calm and rational. But now your perspective has collapsed. “Honey, could I have the paper? I need to see what my stock did today.” An hour now feels like a week, and waiting for the end of the day seems like eternity. With your perspective out of whack, your judgement follows, and soon your paper trading profits turn to real losses. (This, by the way, is why I do not recommend paper trading. Instead I recommend trading with modest amounts of money. That will give you the sense of what speculation is really like, and you will learn to make sound judgements in difficult circumstances.)

And yet, the long term trend is so much easier to play than the short. Look at the trend in this gold bull market. Surely this trend has been our friend. All commodity markets, by the way, are not like this. Each has its own peculiarities, which must be learned by experience. But gold is a good chart commodity. It is produced all over the world, and it is purchased all over the world. Many people, each day, are buying it and selling it. That, of course, is what technical patterns are intended to comprehend, how the average person thinks and what he will do.

The average person, as I have noted, commits the fallacy of the fair price. He believes the teaching of Thomas Aquinas that there is a fair price for every good and that a good ought to sell for its fair price. He does not understand the teaching of Adam Smith that any price agreed upon between buyer and seller is fair, and therefore the crucial determinant of price is supply and demand.

Let us say that our average fellow makes the mistake of selling gold on Feb. 5, at $1,050. “Oh, did that hurt.” He wishes he had not made that move. Well, the answer seems simple enough. If you regret selling, then go in and buy it back. “Oh, no, I couldn’t do that.”

Why, having regretted his sale, can he not go back in and buy? This puts him long of gold again and corrects his mistake. But he cannot buy here at $1,220 because the fair price for gold is $1,050, and he would be overpaying by $170 (he thinks). In short, because Thomas Aquinas did not tell him how to calculate the fair price, he confuses the fair price with the price that is in his mind. It could be the price he is used to because the good has been trading there for a long time. It could be a high or low point on a chart that stands out and comes to people’s attention. It could be a price with a great deal of volume. And, very frequently, it is the price at which he sold (or bought).

Therefore, if the price of gold did get back down to $1,050, our average fellow would rush to buy it because it was now back down to its fair price. And since $1,050 stands out on the charts, many other people would rush to buy at the same time. This buying is called support, and $1,050 is a support level. The corresponding level at which many people will come in to sell is called resistance.

Once we understand the support and resistance levels, by inference we can figure out the larger trend. In the chart above, gold continues to go to new highs, breaking resistance to do so. Every time resistance is broken the bullish trend is reconfirmed. Look at how many times this has happened over the past 10 years.

The old timers noted this phenomenon many years ago. Most market trends are caused by large-scale forces too big for most traders to comprehend. They wind up assuming that current prices are near the fair price, and they are reluctant to pay more. This reluctance slows down the bull trend, but the fundamental, large scale force keeps tilting the balance to the upside. In effect, the idea of a fair price keeps the market undervalued for a long, long time. The old timers expressed this by saying, “the trend is your friend,” and this is as true today as it was in the early 20th century.

Eventually every trend does reverse. But it continues much more often than it reverses. Gold has continued to new highs 8 times since 2001. It has not reversed to a relative low once. In case after case, in good after good we see these giant bull (or sometimes bear) markets that continue for year after year. As we look back from the vantage point of the future and think back to what we were saying at the beginning of the trend, we are amazed. “I was so certain that gold could never get above $70 in 1974.” “I laughed at Robert Prechter for predicting DJI 3500 in 1982.” “I was absolutely certain that T-bill rates could never get to zero.” But in all of these cases, the trend progressed far beyond almost anyone’s ability to predict. All you could say was, “The trend is my friend.” And this kept you long as the market went up and up.

It is undoubtedly the same with the current bull market in gold. This trend will probably go on much longer than anyone now thinks. Indeed, the best prediction of the grand cycle bull move in gold of the 1970s was made by Jim Dines. When asked, early in the decade, how high gold would go, Dines replied that he did not know how high gold would go or how far stocks would fall, but the two numbers would cross. At the time he made that statement, gold was only a little above $35/oz., and the DJI was close to 1,000. It seemed a fantastic prediction. But on Jan. 21, 1980, gold hit an interday high (on the Comex) of $875/oz., and the DJI closed at 872. That $875, by the way, represented a 25-fold multiple for gold in nominal terms and a 12½ multiple in real terms. Between 1966 and 1982, the DJI fell by about 75% in real terms.

It is, of course, tempting to make the same prediction for this grand cycle trend – that gold and the DJI will cross. I am too much of a scaredy cat to make that prediction here, and I think that I will follow the same policy I followed through the 1970s. Turn bullish as the trend broke to the upside and then follow the trend until it had a clear reversal (which turned out to be the giant one-day reversal of Jan. 21, 1980). At that time, the trend was my friend. Today the trend is still my friend. And the trend can be your friend also.

As the trend in gold was nearing its end, circa 1978-79, the speculative end of the precious metals group (silver, the exploration stocks) came to life and made tremendous gains. I look for that to happen as the present bull trend in gold nears its end. That will be a warning sign. Before it happens, we are safe on the bull side. After it begins, we still have a little time.

Now there are a few people who espouse fundamentals and do not look at the trend. These people are called brokers. They make their money on commissions, not profits. For this they need a lot of customers, and so they follow the policy of telling the average person what he wants to hear and what is useful to them (the paper money theories of Foster and Catchings and Keynes and the fair price theory of Thomas Aquinas). Brokers are friendly, but I do not advise listening to them if you want to make money because they are not even trying to discover economic truth. Furthermore the fundamentals being taught in academia and published in newspapers and magazines are a collection of trash. (Keynes was a deliberate fraud and did not believe Keynesian economics.) To make sense of the markets with this false information is almost impossible.

With the mainstream media focusing on the country's leveling unemployment rate, improving retail sales, and nascent housing recovery, one might think that the US government has successfully navigated the economy through recession and growth has returned. But I will argue that a look under the proverbial hood reveals a very different picture. I believe the data shows that the US economy is badly damaged, and a modern-day depression has begun. In fact, just as World War I was originally called The Great War (and was retroactively renamed after World War II), Peter Schiff has said that one day the world will refer to the 1929-41 era as Great Depression I, and the current period as Great Depression II.

For starters, look at unemployment. During Great Depression I, unemployment broke 25%. If government statistics are taken at face value, the current unemployment rate is 9.9%, but a closer look reveals that the broadest measure of unemployment is currently at 20% - and rising. So, today's numbers are in the same ballpark as the '30s even though the federal government is using unprecedented measures to keep the economy afloat. Remember, in Great Depression I, FDR never ran a deficit nearly as large as President Obama's. Moreover, the Federal Reserve of the 1930s still had a gold standard with which to contend, while today's Fed has increased the monetary base with impunity. Yet even with all that intervention, unemployment figures still indicate that we have entered depression territory.

What is demoralizing to an unemployed person is not simply being let go, it is being unable to find a new job for an extended period of time. And this is where Great Depression II really rears its ugly head. According to the US federal government's own data, the median duration of unemployment is now over five months - and rising. This is the highest it's been since the BLS started compiling this statistic in 1965. As workers start to go this long without jobs, they eat into their savings. Eventually - and especially in a country with a savings rate as low as ours and debt as high as ours - they run out of cushion and hit the street. Formerly middle-class people have to make decisions never thought possible: do I eat in a shelter or go hungry in my home?

It's no surprise, then, that about 40 million people - or one out of every eight Americans - are receiving food stamps in Great Depression II. During the height of Great Depression I, the rate was just one out of thirty-five Americans. Even with the stimulus programs, Great Depression II is actually worse on this measure than Great Depression I - and the USDA estimates that the program could grow by another 50%. Soon, out of ten people you know, one may depend on federal assistance for daily survival.

Despite tax credits that have created a rush of purchases this spring, housing is in just as bad shape. During Great Depression I, home prices dropped some 15% from their pre-depression peak (achieved in 1925). In Great Depression II, housing is down at least 30% from the pre-depression peak (achieved in 2005), with some markets down more than 50%.

So, many of the people expected to keep making mortgage payments as they eat tuna fish to stay alive will be paying double their home's resale value. This is a tremendous incentive to walk away, with disastrous consequences for the country's social fabric in these trying times. Empty homes breed crime and vandalism, encouraging more to flee in a negative feedback loop. Moreover, the many 'walkaways' may create a class of Americans with ruined credit - right when many employers have started checking credit scores before hiring.

Even more worrisome, the present drop in home prices is against a backdrop of price inflation. In Great Depression I, our grandparents may have lost value in their home, but everyday goods (milk, diapers, automobiles, etc.) got cheaper at the same time. That made their savings 'cushion' deeper when they needed it most. Today, as home equity (now our main store of savings) declines, prices for consumer goods are rising. It's a tight squeeze indeed.

From jobs to food to the roofs over our heads, the current period of economic turmoil is at least as bad as the First Great Depression, whether or not the financial media wishes to acknowledge it. The main difference is that unlike in the '30s, the US dollar is now the world's fiat reserve currency, so we are able to push our problems overseas for awhile. The plight of the rural Chinese is really our plight - we are living lavishly on the wealth they create. Were they to quit this dastardly arrangement, the full effects of Great Depression II would be felt in America.

By contrast, in Great Depression I, the US was on the gold standard like everyone else, which forced us to live within our means. This, in turn, made it easier to recognize that the economy was in decline and changes had to be made.

Unfortunately, because of the responses of the Administration and the Federal Reserve, which I believe to be deeply misguided, I remain concerned that Great Depression II could develop into something far more devastating than its predecessor, something that other countries in the world have experienced but was thought impossible in the United States: a hyperinflationary depression. As bad as the current downturn has been, inflation would make it immeasurably worse. It would require an honest accounting of the problems we face today to avert the disaster we see coming tomorrow.